CIMA Global Business Challenge Case Study- YJ Oil And Gas IndustryLord Buddha Education Foundation (LBEF)

Sikkim Manipal University

3 / 3 1 / 2 0 1 5

Team Incredible

Name of Participants:

Rahul Kothari. Megha Lath. Nisha Agrawal. Saurav Lunia.

Case Study

YJ-Oil and Gas Industry Case –March 2015

REPORT

To: YJ BoardFrom: Management Consultant Date: 31 March 2015

Review of issues facing YJ

Content

Part-A1.0 Introduction2.0 Terms of reference3.0 Prioritisation of the issues facing YJ4.0 Consideration of the issues facing YJ5.0 Recommendations6.0 Conclusions

Part-B Financial Analysis

Appendices:Appendix1 SWOT analysisAppendix2 PEST analysisAppendix3 5 force analysis

1.0 Introduction

YJ is a small E&P oil and gas company which was listed on the AIM in 2007. It has been successful to date and already has three oil and gas fields in production (AAA, BBB, and CCC), however DDD has been winded up due to uneconomic production. It has beenrecently awarded the licences for EEE, FFF, GGG, and an oil and gas field off the coast of an Asian and African country. However, it was unsuccessful to achieve the licence for HHH due to facilitation payments. YJ’s geologists and survey teams are currently investigating other potential oil and gas fields. YJ also have received a farm-out proposal from a firm named Liquid Gold (LG) to share GGG new oil and gas field returns as per the criteria mentioned by them.

YJ’s share price rose shortly after it was listed in aim. However, shareprice has fluctuated during 2013/2014 due to illness of Oliver Penn. After experiencing over five years of losses,YJ is now finally able to generate revenue in the year ended 31st march 2014 which is expected to be a start up for the company. It has also set new record of the highest level of share price i.e., US $35 per share after it won the right to drill new three different fields (EEE, FFF, GGG).

2.0 Terms of Reference

We are the management consultant assigned to write a report to the YJ Board which prioritises, analyses, and evaluates the issues facing to the board of YJ and make appropriate recommendations .

We have also been asked to draft various financial statements of YJto estimate its financial capacity based on 31st march 2014 figures and forecast 31stMarch 2015 figures to evaluate if they could afford drilling all three sites. And also recommend whether to go ahead with the farm out offer or not.And the company’s financial position/capacity has also been analysed.

3.0 Prioritisation of the issues facing YJ

3.1 Top priority- Licence (Test drill)

The first priority is providing a broader assessment whether YJ could afford to test drill all three sites (EEE, FFF, and GGG). Ullan Shah is delighted with the news but he is unsure whether YJ has the financial or managerial capacity to test drill all three sites.The licence offers are open for acceptance for a two week period only.

3.2 Second priority- Recruitment

This issue is considered to be the second priority as drill IT limited, the chosen outsourcer at the AAA field in off coast of an African country is finding difficult both to retain staff and to recruit replacements due militant attacks.There is also a discussion concerning whether there is a need to change company’s security policy as well as to strengthen on its system of control and operations.

3.3 Third priority-Farm out proposal

This is considered to be the third priority as the YJ is considering an interesting farm out offer from a business called liquid gold (LG). Normally a farm out deal is negotiated at the time a field is ready to be farmed out but if LG has offered an option payment, payable now, which will give it the right but not the obligation to produce the oil in field GGG from 31st march 2016.

3.4 Fourth priority-Security and conventional reserves in challenging area

This is considered to be the fourth priority as the head office was attacked by the greenbies party about the use of finite fossil fuels use. YJ board has also suggested YJ needs to consider its long term future with specific regard to the inherent lack of sustainability of fossil fuel.

4.0 Considerations on issues facing YJ

4.1 Licence test drill-As YJ is based on upstream sector, so the company need to acquire the licence to operate in oil and gas field for exploration and production. The government of the country which owns the onshore or off-shore land will issue a licence based on set of criteria. The various criteria are as follows:

a. Its technical ability to bring the potential oil and gas fields into production.b. Its awareness and track record in respect of environmental issues.c. The company’s financial capacities in respect of the investment require bringing

the oil and gas field into production.

4.1.1 Advantages to acquire licence:a. It is beneficial if successful in test drilling.b. It increases the reputation of the company.c. It builds confidence among the investors for further investment.

4.1.2 Drawbacks for acquiring licence:a. Only two weeks’ time for acceptance of licence on (EEE, FFF,

GGG) fields.

b. No oil and gas reserve found on the field DDD subsequent to test drill.

c. It has a limited financial and managerial capability to test drill all three sites.

4.2 Recruitment

YJ outsources all of its drilling work to specialised companies, so it employee fewer employee. At the end of March 2014, it employed fewer than 200 employees. Of these employees around half of them work on the exploration of potential new oil and gas fields. Of the remaining employees of YJ, where is a small specialized team which works on licence applications and the rest are involved with the management and supervision of operations at YJ’s three current operational oil and gas fields.

4.2.1 Advantages of recruitmenta. Appointment of competent employees to manage activities.b. Selecting, appointing, and effectively managing competent

outsourced contractors.

4.2.2 Disadvantages of recruitmenta. Recruiting and retaining a motivated workforce with the required

skill set.b. Signature of Mr Paul Brown was forged due to inefficient

supervision.c. Shortage of skilled oil and gas manpower, which is an industry wide

problem.4.3 Farm out proposal

It is to assign or sell an interest in a licence to another oil and gas production company. YJ is considering an interesting farm-out offer from a business called Liquid Gold (LG) for GGG oil and gas field. LG has offered an option payment, payable now, which will give it the right but not the obligation to produce the oil in field GGG from 31st march 2016.if GGG has commercial reserves then LG can extract them should they wish, but if GGG proves to be barren of oil and gas the option payment is kept by YJ.In this way the option deal carries risk for LG.

4.3.1 The offered option deal is as follows:

1. The option payment is US $ 10m payable on 31st august 20142. The field test drilling must be completed and reserves independently

proven by 31st march 2016.If the date is exceeded YJ will have to pay US $ 1m without limit.

3. LG requires presence at the board meeting of YJ and up to date progress of GGG field.

4. The US $ 10m is to be held in an escrow account.5. LG wants 10% discount on oil and gas discovered in the GGG field.

4.3.2 Merits for accepting the farm-out proposal.

1. It will financially support YJ Company.2. It will distribute risks of test drilling of GGG field with LG Company.3. It will help to establish healthy relationship with LG Company.4. It will also increase manpower required for test drilling.

4.4 Security and conventional reserves in challenging areas

Health, safety, and environmental issues are firmly placed at the top of YJ’s objectives. YJ wishes ensure that it actively prepares for and manages the risk it faces in the hostile and difficult environment in which it operates. Lee Wang, director of health, safety and environment, considers that accident prevention is the key factor in oil and gas industry.

Due to some international terrorist incidents in early 2013, Lee Wang persuaded the board to appoint an international security company. This security company provides trained personnel to improve the security at all YJ’S test drilling and production drilling locations.

4.4.1 Strengths

1. Continuous improvement of HSE performance by monitoring, reporting and on site audits.

2. Preparing and testing response plans to ensure that any incident can be quickly and efficiently controlled, reported on and action taken to ensure that it does not re-occur.

3. Developing specific HSE plans for each potential oil and gas fields depending on the local and environmental conditions.

4. Strive to protect the environment in which it operates.

4.4.2 Weakness

1. Considering sustainability issues-oil and gas are finite resources.2. Managing the risk of oil and gas exploration which results in an

unsuccessful oil or gas fields that cannot be taken into production.3. Managing the risk of accidents.4. Managing the threat posed by terriost activities.5. Managing other risk including financial, political and operational risks –all

E&P companies carry out extensive risk assessment.5.0 Recommendation

5.1 Licence

The financial position of YJ Company is estimated to be strong enough to bear the expenses of test drill for all the available fields. However, before obtaining a licence on any of the field it is the prime responsibility to ascertain whether all of the fields can be brought to production with the finance options available with the company. It is recommended to Ullan Shah to show the importance of oil and gas to the public of that particular area.

5.2 Recruitment

As the whole of the oil and gas industry is suffering from a skill shortages, if YJ is going to continue to grow and compete with other small E&P companies as well as the multinational oil and gas companies, it will have to reward its employees based on competitive salaries and other benefits. The board of YJ needs to agree how to establish a suitable pay and reward structure in order to be able to recruit and retain adequate number of operational managers.

There is a need for the board to discuss and agree whether salary alone adequate to retain and also recruit the number of new employees that YJ will need in order for it to grow. It may also be necessary to offer free shares in YJ, linked to achieving performance related objectives, as the only way to attract new mangers.

The board of YJ had decided to only pay a slight salary increase .This could be considered to be a temporary solution and may possibly work in the short term but will not address the underlying skill shortages and the need for YJ to retain the best employees and to encourage these employees to stay loyal to YJ.

So it is recommended that YJ should establish a share ownership scheme for all of YJ’s management level employees.

It is also recommended that YJ should establish and apprentice scheme and should recruit graduate trainees and train them in all areas of YJ’s operations.It is also recommended to appoint an experienced CFO, as Orit Mynde is ill, to take decision for the company with an internal member who can explain about the company.

5.3 Farm out proposal

The acceptance of farm out offer shows a positive cash flow of over 22 million. In conditions where it is certain that the company’s financial position is not viable to meet the production requirements of all the newly obtainable licenses, it is beneficial for the company to make profit by accepting the offer. Also, in case where if the reserves are

proved to be barren, the company will not suffer entire loss of test drill operation (which it has to bear in case the same is carried out without the same being farm out).

5.3 Security and conventional reserves in challenging areas

There is a great threat of international terrorism which remains a significant problem .Just because there has not been any incident to date doesn’t mean that they will not occur in the further it is recommended to improve level of security than the previous year.

It is also recommended that all the employees undergo safety awareness training regularly.

It is also recommended that all outsourced personnel employed at YJ’s drilling rigs undergo rigorous security checks so that its sites are not exposed to any foreseeable terrorist threat.

It is also recommended that YJ’s management liaise closely with the European government agencies on possible terrorist alerts as well as the governments of the countries in Asia and Africa, in which YJ’s licensed oil and gas fields are located.

As known, oil and gas reserves are not to last forever and will someday extinct as such processes are being carried out to either prolong or replace this oil and gas reserves with possible substitute. Some remedies being adopted are as follows:1. Technological advancements e.g., Hydraulic fracturing, Solar Plants, etc.2. Conducting searches for new natural gas fields.3. Production of gas reserves.6.0 Conclusion

The company is experiencing growth in its operations and achieving growth in its financial operations. The share prices have gone from $6 during its incorporation to $35 in a span of 7 years. The upward trend in revenue and profit clearly shows that there is a lot more for the company to achieve soon. Although the products of the company are perishable in nature there are still new opportunities available. Even when all the fields could not be brought into production due to reasons as lack of finance, options such as farm out are still available. And, even the financial institutions break their pre-defined protocols when they view a sharp growth in a company like YJ. As per the past history and the non-ending need of oil and gas products, it is suggested to carry the works as an E&P company even after the existing fields runs dry. But it is not a limitation for the company to enter new product line or invest in some sort of energy projects and build a portfolio of energy alternatives.

The financial position of YJ Company is estimated to be strong enough to bear the expenses of test drill for all the available fields. However, before obtaining a licence on any of the field it is the prime responsibility to ascertain whether all of the fields can be brought to production with the finance options available with the company. Also, farm out options should

be analysed and on satisfaction of same, the company should move forward in further procedures.

Part-B

Financial Analysis

1. Financial Capacity of YJ Oil & Gas Industry as on august 1, 2014

Right Issue ($ in millions)

Existing Share Capital 10.00 Share Premium 50.00 Addition: Right IssueShare Capital 2.50 Share Premium 72.00 Total Addition 74.50

Note: Assuming 1 right share issued on every 4 shares held and discount given 15% on share price of $35 per share (Share price rose to $35 when licence for new test drills were available)

Cash Available for Expenditure

Cash Balance at the year end 13.60 Less: Tax Payable (0.50)Cash Available 13.10

Addition in Loan

Existing Loan 140.00 Total Loan Available 171.00 Addition in Loan 31.00

Bank Overdraft 5.00

Total Cash Available 123.60

1. Financial Capacity of YJ Oil & Gas Industry as on April 1,2015:

Right Issue ($ in millions)

Existing Share Capital 10.00 Share Premium 50.00 Addition: Right IssueShare Capital 2.50 Share Premium 72.00 Total Addition 74.50

Note: Assuming 1 right share issued on every 4 shares held and discount given 15% on share price of $35 per share

Cash Available for Expenditure

Cash Balance at the year end 80.20 Less: Dividend Payable (10.00)Cash Available 70.20

Note: Since tax is payable after 9 months of year end, the same is not taken in consideration

Addition in Loan

Existing Loan 140.00 Total Loan Available 214.80 Addition in Loan 74.80

Bank Overdraft 5.00

Total Cash Available 224.50

Conclusion: The financial position of YJ Company is estimated to be strong enough to bear the expenses of test drill for all the available fields. However, before obtaining a licence on any of the field it is the prime responsibility to ascertain whether all of the fields can be brought to production with the finance options available with the company. Also, farm out options should be analysed and on satisfaction of same, the company should move forward in further procedures.

Farm out offer for field GGG to LG:

1. When reserves are not proved barren:

Initial IncomePayment from escrow account

Assumed Date

($ in millions)

PV- 1 Aug 2014 Assumptions

First 1-Aug-14 2.00

2.00  

Second 1-Aug-15 2.00

1.80

Assuming it takes 4 months to drill 100m

Third31-Mar-

16 6.00

5.05

Assuming test drill is completed on time

Regular annuity

Figures($ in

millions)PV- 1 Aug

2014 AssumptionsPayment per mmbbl/mmbble

9.90      

Payment per year 4.95      

Reserves (mmbbl) 10.00      

Unexpired period of receipt (in years)

20.00    

Assuming 0.50 mmbbl/mmbble of oil and gas is extracted every year

Present value of annuity as on 31 march 2017  

39.42

29.86

Assuming payment is received in year end

Present value of all receipts as on 1 Aug 2014 38.71 Present value of all payment as on 1 aug 2014 (16.22)Profit in Farm Out 22.49

Note: Since test drill has to be commenced on 31 March 2015 the PV of expenditure is calculated.

2. When reserves are proved barren:

Present value of all receipts as on 1 aug 2014 8.85 Present value of all payment as on 1 aug 2014 (16.22)Loss in Farm Out (7.37)

Conclusion:

The acceptance of farm out offer shows a positive cash flow of over 22 million. In conditions where it is certain that the companies' financial position is not viable to meet the production requirements of all the newly obtainable licences, it is beneficial for the company to make profit by accepting the offer.

Also, in case where if the reserves are proved to be barren, the company will not suffer entire loss of test drill operation (which it has to bear in case the same is carried out without the same being farm out).

YJ Long Term Future:Growth of YJ

Volume% Increase

2013/14 to 2014/15 2012/13 to 2013/14Increase In Revenue 13% 47%Increase In Gross Profit 18% 52%Increase In Operating Profit 26% 60%

1. Statement of Equity and Assets:Statement of Financial

Position As at As at

3/31/2015 3/31/2014 US$ US$

million million      Non-current assets (net) 191.0

0 189.0

0 Current assets    Inventory 15.0

0 25.0

0 Trade receivables 8.5

0 6.5

0 Deferred tax

-

- Cash and cash equivalents 80.2 13.6

0 0 Total current assets 103.7

0 45.1

0 Total assets 294.7

0 234.10

     Equity and liabilities    Equity    Issued share capital 10.0

0 10.0

0 Share premium 50.0

0 50.0

0 Retained earnings 44.3

0 1.7

0 Total Equity 104.3

0 61.70

     Non-current liabilities    Long term loans 140.0

0 140.0

0      Current liabilities     Bank overdraft

-

- Trade payables 36.9

0 31.9

0 Tax payable 13.5

0 0.5

0 Total current liabilities 50.4

0 32.40

Total equity and liabilities 294.70 234.10

1. Income Statement:

1.1.1.1.1.1.1.1.1.1.1.1.1.1.

Cash Flow:

Particulars Year ended 3/31/2015

Cash flows from operating activities:  Profit before taxation (after Finance costs (net)) Adjustments: 56.10    Depreciation & amortisation of E&P drilling costs 28.00 Finance costs (net) 15.50   43.50    (Increase) / decrease in inventories 10.00 (Increase) / decrease in trade receivables (2.00)(Increase) / decrease in deferred tax asset - Increase / (decrease) in trade payables (excluding taxation) 5.00   13.00    Finance costs (net) paid (15.50)Tax paid (0.50)  (16.00)   Cash generated from operating activities 96.60    Cash flows from investing activities:  

Profit or Loss Statement Year ended Year ended 3/31/2015 3/31/2014

  US$ US$   million million      Revenue 196.30 174.00 Cost of sales 102.10 94.40 Gross profit 94.20 79.60 Distribution costs 0.50 0.50 Administrative expenses 22.10 22.10 Operating profit 71.60 57.00      Finance income 0.10 0.10 Finance expense (15.60) (15.60) Profit before tax 56.10 41.50      Tax expense (effective tax rate is 24%)

13.50 0.50

     Profit for the period 42.60 41.00

Purchase of non-current assets (net) (including capitalised E&P costs) (30.00)Cash used in investing activities (30.00)   Cash flows from financing activities:  Dividends paid - Cash flows from financing activities -    Net increase in cash and cash equivalents 66.60    Cash and cash equivalents at 31 March 2014 13.60       Cash and cash equivalents at 31 March 2015 80.20

1. Oil Production

         Production in year to 31 March 2014:        Oil – bopd

1,500.00 1,200.00

800.00

3,500.00

- mmbbl 0.55

0.44

0.29

1.28

Total oil revenues US$million 60.30

48.20

32.10

140.60

Gas – boepd 1,500.00

2,000.00

1,500.00

5,000.00

- mmbble 0.55

0.73

0.55

1.83

Total gas revenues US$million 10.00

13.40

10.00

33.40

Total oil & gas revenues for year ended 31 March 2014

70.30

61.60

42.10

174.00

US$million                 Production in year to 31 March 2015:        Oil – bopd

1,500.00 1,200.00

1,040.00

3,500.00

- mmbbl 0.55

0.44

0.38

1.28

Total oil revenues US$million 63.40

50.70

43.80

157.90

Gas – boepd 1,500.00

2,000.00

1,950.00

5,000.00

- mmbble

0.55 0.73 0.72 1.83 Total gas revenues US$million

10.60 14.00

13.80

38.40

Total oil & gas revenues for year ended 31 March 2014

74.00

64.70

57.60

196.30

US$million        

Appendix 1- SWOT analysis

Strength Awarded with lots of licence for

drilling Strong revenue and profit after early

losses New CEO with a good reputation Increases in share value

Weaknesses Lack of finance for drilling Current shut down of EEE Shortage of experienced managers Bank not willing to give loan

Opportunities YJ is waiting to hear whether it will

be awarded three further licences in Asia.

Future full stock market listing Further farm-out arrangement in the

future to help finance drilling costs YJ could secure funding from LG in a

farm-out arrangement

Threats Terrorist activities

Shortage of skilled oil and gas manpower, which is an industry wide problem

CFO, Orit Mynde, became ill

Appendix 2-PEST analysis

Political Ability of YJ to win licences from different government. Risk of terrorist incidents.

Economic Increasing demand for oil and gas putting pressure on prices.

Improving profitability and lowering operating costs through the use of new technology.

Impact of interest rates on YJ’s debt financing.

Social Cost of oil and gas affects demand. Current increasing consumer and business demand for oil and gas.

Technological Improving operational performance through the use of new technology. Improved technology to help improve of quality.

Appendix 3Porter’s Five Force analysis

1. Intensity of rivalry among competitors

Some industries appear inactive because of a low level of rivalry among competitors. YJ is highly competive and is able to face the challenges due to prevailing competitions

2. Power of buyers

From an industry point of view, the buyers can usually be classified into three major categories i.e., consumers, industrial customers and commercial customers. Customers include the purchasers of the firm’s service or product of their own use. Industrial buyers include the companies which purchase the firms product or service to be used as a component in its product. Commercial customers include other companies that sell companies product to customers.YJ potential buyers are commercial customers and industrial buyers .After production of oil and gas YJ transport oil and gas by tankers to port it to its respective customers as per the deal of the contract.

3. Powers of suppliers

The supplier of goods and services to an industry has the power to influence their customers through their ability to set price of control quality, delivery time and order quantity. If these customers can manage successfully one supplier against another to protect their interest then the industries profit can be drained off by the suppliers.

4. Substitute products

Substitute products refer to those products of industries which serve consumer needs. Existence of close substitute represents a strong competitive threat which limits the price fixation of product and profitability of the firm. Conversely, if the firms product have very less substitues, then the company has t5he opportunity to raise prices and make additional profit. It is an eye opener for the firm to select those lines which have least substitutes.

5. Potential entrants

New entrants to an industry pose several threats to existing competitors. New competitors can reduce the market shares of participants by dividing the pie into more pieces.

The End